Sunday, 9 July 2017

Article Preview – “Artificially Increasing Competition in the Credit Rating Industry: The ESMA Meets an Immovable Object” – European Company Law

Today’s post previews a forthcoming article by this author,
entitled ‘Artificially Increasing Competition in the Credit Rating Industry:
The ESMA Meets an Immovable Object’, which will be published in the European
Company Law Journal (available here in
a pre-published form). The paper is concerned with the recent push by the
European Securities and Markets Authority (ESMA) to enforce an increase in
competition within the credit rating industry, particularly with regards to the
rating of structured products. However, even though the rules that dictate that
regional authorities must endeavour to enforce this new regulatory drive are
clear, an analysis of the reality of the situation reveals that the only actor
that can realistically dictate the movement of the industry, with regards to
its output and internal competition, are the investors who use the ratings of
the largest agencies.

The article begins by looking at the regulatory and
legislative attempts from both the U.S. and the E.U. in response to the rating
agencies’ complicity in developing the financial crisis, with the Dodd-Frank
Act of 2010 and the three
E.U. regulations seemingly aiming for two important supporting aspects of
the agencies’ modern position: regulatory reliance and a lack of competition. Regulatory
reliance has been tackled by removing reference to credit ratings in official
documents and guidance, but this has had a limited
effect due to the protections appropriated by the agencies. With regards to
the issue of competition, the E.U., via the ESMA, is attempting to put an
enforcement strategy in place regarding competitive issues in the form of
enforcing the usage of smaller agencies by issuers who are issuing debt that
requires two or more credit ratings. Yet, as Partnoy notes
regarding the regulatory reliance issue, the same fundamental problem persists
with regards to competition, and that is that investors are at the heart of
determining change in this particular industry.

The E.U. has dictated that, based on the legislative orders
found in CRA III – the third in a series of credit rating agency-focused
regulations – ‘measures
should be taken to encourage the use of smaller credit rating agencies [by way
of] where two or more credit ratings are sought, the issuer or a related third
party should consider appointing at least one credit rating agency which does
not have more than 10% of the total market share’. The article, having
positioned this approach, then seeks to assess the reality of the situation,
and ultimately finds that there is little substance to the move. For example,
where the issuer does not select the smaller agency to rate its issuance, the
issuer must only document that they
did not do so and detail some reasons why. The paper takes issue with this
suggestive stance by detailing that were there are gaps in the regulation,
financial entities will almost always exploit them. The obvious circumvention
for issuers is to claim that the smaller agencies, who are incredibly small and
under-resourced when compared to the Big Three, simply do not have the
expertise nor resources to adequately rate the issuances at hand; whilst this
is not really true because a number of smaller agencies have a high degree of
accuracy when it comes to rating, the rationale in that defence has two
important connotations. Firstly, the claim by issuers regarding size allows
them to circumvent the regulations that have been put in place. Secondly, the
basis of the claim reveals that the driving force in this arena are investors,
as the reputation of the smaller
agencies is what is actually the sticking point for issuers – investors simply
do not allow for the smaller agencies to be selected as it increases,
theoretically, the borrowing costs for the issuer via a less reputable credit
rating source. Whatever the rationale, the paper finds that the regulations are
simply not being adhered to, with the ESMA admitting that ‘unfortunately,
successful implementation of these Articles has been hindered by a lack of
clarity in a number of key areas’.

However, the actual response by ESMA to this obvious outcome
is rather disheartening. Firstly, it suggests that all Sectoral Competent
Authorities – the nominated financial authorities from each region in the E.U. –
should converge to enforce the ruling. Secondly, ESMA reiterates the rules that were originally posed in the aftermath of
the Crisis. That is it. The dejected tone in the supervisory briefing falls in
line with the academic tone that has revolved around the industry for years:
rating agencies do not act within the law, and the interested parties i.e.
issuers and investors, perpetuate this phenomenon. Yet, the paper suggests that
the proposed aims of the regulations are not wrong, but simply misguided. In order to demonstrate this point,
the paper proposes that the concept of ‘position’ be applied to the industry
and its connected parties, after which a clearer understanding can be establish.
For example, on a number of occasions here in Financial Regulation Matters we have discussed the divergence
between the reality of the situation and what is desired by outside parties,
and ESMA has unfortunately fallen foul of this divergence like many before it.
To explain, it is almost impossible under the current confines of the rating
industry to enforce increased competitive
pressures upon the Big Three because, quite simply, the natural oligopolistic structure of the industry dictates that it
cannot. It is a natural oligopoly because investors, who are either a. retail
investors who have a need for quick decipherable information or b.
sophisticated investors who represent, usually, a large group of dispersed
investors who again rely upon easily decipherable information, perpetuate the
use of ratings simply because of their ease. If we align the fact that,
traditionally, the corporate ratings
of the agencies have been incredibly accurate, then the reputable basis that understanding
develops means that investors will continue to rely upon what is seemingly easily decipherable and relatively accurate guidance.Arguably, what is required on the back
of that understanding is an increased awareness of the differentiation in the
rating agencies’ outputs, and the historical accuracy of each stream; whilst corporate
ratings have been accurate (as it is easier to obtain necessary information and
rate it accordingly for a corporate body), the same cannot be said for structured product ratings, which have
been incredibly inaccurate due to the propensity of the agencies to reduce
their analytical thoroughness for increased fees, whilst it also true that
rating structured finance products – which may contain ‘pools’ of products like
mortgages that can rank in the thousands in any given structured finance
issuance – is tremendously difficult, time consuming, and resource intensive.
Investors then are left with a simple choice between agencies who do not,
potentially, have the resources to conduct such intensive investigations but
have cleaner reputations, and agencies who do have the resources to conduct
investigations, but who have traditionally not done so and who have incredibly
poor reputations in the markets within which they are investing – quite a dilemma
that only has one realistic outcome. In making this point as its conclusion,
the paper proclaims that until regulators start to act on this differentiations
and look at the roles the interested parties actually play, then there can be no development in this particular
field.

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